The Amateur Investor Ep. 19: Qualitative Valuations
Up front, I’d like to apologise if this seems helpful at first, then wholly unhelpful. At least that’s what it felt like to me when I sat down over Discord with a friend of mine from the coast who offered to talk me through the Gordian knot that is stock valuation.
After much back and forth, I finally managed to nail down some semblance of a step-by-step process for understanding stock valuation. It is by no means comprehensive, in fact it barely covers the full range of techniques required and factors that need to be considered. This is not the be all and end all, in fact it’s important that you always do your own due diligence, which includes reading any one of the hundreds of books that exist on the subject of investing
But the journey of a thousand miles (or in this case, articles), starts with a single step.
When you’re looking at a company to invest in, there’s a few questions that need to be answered thoroughly before the actual stock purchase. The first phase of these questions should be answered covering the period of the last 5 to 10 years, with as much detail as possible.
Probably one of the first questions that should be asked before any of these are if the company is publicly listed on the stock exchange. Without having held an IPO, there’s no point to doing much of the workup, and you’d probably be better off looking for an ETF or a mutual fund.
The company
- What does this company do?
- What are they known for?
- How long have they been around?
- What do people say about their services/products and reputation?
- What have they been doing lately?
When gathering research, it is good to employ some basic critical thinking, particularly in terms of where you get your information from. It can be difficult to list exactly what sources to look at, since it can tend to vary based on the industry.
A good starting point is Livewire Markets, which covers pretty much anything in the financial world in Australia. If you’re looking to invest in the nation’s burgeoning resource market, Resource Rising Stars should probably be your first port of call. It’s also not a bad idea to just check out the company’s website, since they’ll tell you what they do and possibly what their next moves are.
For a much wider view of the ongoings in the world of finance, The Motley Fool and Seeking Alpha cover a wide range of topics in investing and finance. These won’t really inform you specifically about the stock you’re looking to buy per se, but they are good to just stick in your daily reading list.
Commitment to learning is key.
Now for some practical work
This is by no means a comprehensive guide to valuation, rather think of it as my initial research into. I’ll probably come back in later articles with more depth and hopefully more knowledge. Nevertheless, each step of this itinerary is headed by questions that you need to answer in order to fill out the gaps in your understanding.
What’s the company worth to the market?
A good first step is to figure out what the market says about the company, the market capitalization, which will tell us the company’s worth according to the stock market. The formula for this is relatively simple;
Market Cap = Share price for the period x the total number of shares issued.
While this is by no means a singular yes or no answer to the question of “should I buy this stock?”, it is an easy first step to getting more information to help you make your decision.
The output of your calculations will typically fall into three categories; large-cap ($10-billion and above), mid-cap ($2 to $10 billion), and small-cap ($300 million to $2 billion).
For example,
What are their operating costs like?
Get your hands on their financial position statements, which should generally be accessible online at:
You might also find them through your trading platform, Commsec offers built in access to company financials as well as a slew of other metrics and data points to help your trading. There are a few key indicators that you’ll want to look at.
- Operating income before impairment losses and operating expenses
- Net Profit for the period (Comparing this against the Market Cap for the period as a percentage gives us the earnings for the year roughly)
- Earnings per share basic and diluted
What’s new in the business?
This is probably best answered by looking at the Pro-Forma Financials and any announcements or news from management, which will contain information about potential business developments. The best way I’ve found to go about this is to pull all of their official announcements and reports, and read. It may also be helpful to you to take notes along the way. If you’re an old-school guy like me, you may even wish to print the reports and announcements out and make notes on them to help organise your thoughts. You basically want to build a decent amount of historical data covering shifts within the company, changes in operation etc.
That’s just the non-mathematical stuff of stock valuation, and even then it’s not the half of it. Like most valuations, it’s worth it to do valuations for a bunch of time either side, Hsuan’s recommendation if I recall correctly is about 5 years (I’ll go ahead and say here that in the drafting of this article, Hsuan commented that like all rules, this one is made to be broken. The specific circumstances of said breaking I’ll leave for him to explain)
Originally, I was going to write this as a full article, but opted not to once I realised just how interconnected each individual aspect of valuation is. Next issue I’m going to try to cover as many methods of valuation as I can, doing a medium dive on each method to hopefully explain what they’re good for.
For now, go slow, play small and learn the process.
